Time is the greatest enemy for venture-capitalists?

Surf’s up

Philip Zimbardo published a paper in 2007 called The Lucifer Effect. Philip’s study claims “being part of a group often suspends individual moral reasoning and responsibility,” portraying the biological nature of man to gravitate towards a cult or a group. Robert Cialdini, an American psychologist in 1984, in Social Proof, also claimed “We view a behavior as more correct in a given situation to the degree that we see others performing it.”

The reality is investor psychology is not dissimilar. Whether it’s the internet in the 90’s, e-commerce or AI, venture-capitalists will gravitate like surfers chasing the next wave.

The inverse relationship with time and start-up investments

I give VCs a lot of stick - maybe I’m a little harsh. But after decades of poor investment strategies coming to light, I’ve begun to question the origin of venture psychology. By definition, the term “venture” means a few things. In start-up terms, it refers to a new business or project, while in general use, it means “to take risk” or “to be brave.” But my question is, how brave do you need to be? There’s a fine line between being brave and being stupid, and time and time again, we’ve seen companies get burned both privately and publicly because venture capital has caused major inefficiencies in the way they manage their operations.

Putting biological tendencies aside, what risk are venture capitalists actually taking on when they decide to fund a start-up? Let’s look at the numbers from the United States Bureau of Labor Statistics to take a closer look:

10% of start-ups fail within the first year. 25% of start-ups fail within 2 years.45% of start-ups fail within 5 years.75% of start-ups fail within the first 15 years.

Therefore, as an investor targeting a start-up by definition, you should acknowledge that the longer you hold a position in your portfolio, statistically, the higher the risk of failure, assuming the vast majority of start-ups fail financially. The reason a company failing within the first year is relatively low is that it’s unlikely the business will grow to a size of meaningful returns or losses in such a short period. This “inception” phase is still very much a discovery phase for founders and investors, and it’s hard to see the “risk-reward” come to life so early in the narrative.

However, as the business scales, the fundamentals of that business start to reveal themselves, and the returns or losses begin to compound more and more aggressively. Therefore, the returns relative to the total portfolio value start to increase, and the decision from the LPs (limited parter / lender) and the VC to cut any losses becomes more incremental relative to the value of the portfolio.

In simpler terms, the data suggests start-up performance has an inverse correlation to that of the market. If you invest in the S&P500 (often the benchmark for investors), the longer you hold your position, the lower the risk of failure over a long period of time, with the added value of diversification across 500 positions. It’s this risk that contributes massively to the venture psychology of selling an asset quickly, before it’s too late.

As an example, let’s assume a business has already surpassed its seed round and is searching for its first big home run to raise a Series A. At that stage, a large chunk of their forecasts are still hypothetical. There’s a lot of “in theory, if we get X amount in sales” and “if we can scale at this rate, we’ll get X.” There are far too many factors outside the business's control to rely purely on hypotheticals, and poor due diligence on the risk factors will render these irrelevant very quickly.

Therefore, if the business has yet to turn a profit, the VC must now accept that by accelerating the company's growth, they are potentially increasing the risk of compounding losses. This is because a growing business that remains unprofitable may stay operational longer, thereby increasing the chance of failure by pouring more fuel on the fire.

**The irony of that metaphor is they are quite literally burning money by doing this.**

As a LP, what’s the point in giving your money to a VC?

For a LP (a bank or a fund) deploying capital to a VC, what’s the added upside?

The birth of venture capital is directly correlated with the rise of technology, as the ability for software to fuel growth has led to a greater potential upside return for the LPs. With the rise of revenue generated by technology has come the rise of capital in circulation within the U.S. economy, with Silicon Valley outpacing Wall Street since the early 2000s. Venture capital, therefore, has always seemed to be an exciting prospect for investors looking for home runs.

However, the way I see it, we’ve hit a catalyst point where the risk-reward of investing in start-ups has dropped, and the incentive for LPs to lend money to a VC instead of investing in the market has declined. The same applies to hedge funds who are under increased scrutiny for charging astronomical fees for sub-par returns. So, why now more than ever?

As the largest tech companies in the World (also known as the Magnificent 7) continue to surpass the growth rates of other stocks in the index, the compounding returns of the index has become more dependant on the growth of these businesses. As a result, the NASDAQ and the S&P500 are now reliant on the performance of the same stocks (read more). This means the risk associated with the index is less diversified than before. So from a LPs point of view, if you want to be heavily leveraged on technology stocks, that not only show high growth rates but also a lower risk of failure, wouldn’t it make more sense to invest in a S&P tracker instead?

Inventing valuation models, just to pass the bag on to the next investor

As a way to justify investing in start-ups that don’t make money (or even if they are breakeven), venture capitalists invented revenue valuations, selling businesses on absurd multiples based on growth in sales, not on performance. Ultimately, finding a bank to take their holding public is the only saving grace for VCs in a sticky situation, especially if they’re holding a big business that’s burning cash, they can’t sell. This way, they can sell the idea of keeping the holding on the books to a LP and justify making their fees in the meantime. If the company gets big enough to find a bank to take it public, hallelujah - VCs can sell their stake to the public.

Unfortunately, as we’ve seen cyclically since the inception of public markets, investors have always gravitated toward risk. Like gamblers, investing in early-stage businesses, despite heavy due diligence, will always be a high-risk strategy. As a result, we’ve seen waves in public markets with inflated valuations, fuelled by growth from venture capitalists. The only difference between gambling and investing is that with investing, you can sell your hand to the player next to you. Now it’s their problem.